Buy low and sell high, right? We've all heard it, and it sure makes sense. How else can you make money, after all, other than by selling something for more than you paid for it?
But it's easy enough to trip up, often because we get excited by a stock's momentum and don't check to see whether it's undervalued.
And it's that last bit that makes it likely that you'll be able to buy low and sell high.
Stocks on sale
Value investing seeks, essentially, to buy a dollar for 50 cents by buying companies that are undervalued relative to their intrinsic worth. The difference between what a company is worth and what it's selling for (assuming the former is higher) is called the margin of safety.
As Benjamin Graham, the father of value investing, famously said, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine." In other words, while we can't predict what the market will do in the short term -- because it's subject to the whims of investors -- over time, the stock price is likely to rise or fall to somewhere near fair value. If you've bought stocks with significant margins of safety, you're likely to benefit from that market weighing.
But how do you determine intrinsic value -- and thus whether a stock is undervalued? The most comprehensive and effective way is through doing a discounted cash flow (DCF) analysis.
But DCF, while impressive, is complicated and time-consuming. Although it's great for making final decisions, it's not so good for winnowing down the universe of potentially undervalued stocks -- and right now, that universe is pretty darn big.
A combination of simpler metrics, on the other hand, can help you narrow that universe down into something more manageable.
Price to earnings
A company's price-to-earnings (P/E) ratio, which divides the current price by the recent annual earnings per share (EPS), shows how much people are currently paying for every dollar of earnings.
A high P/E means investors are excited, and a low one means the opposite. In theory, lower P/Es mean the stock is more likely to be undervalued, because investor pessimism has driven down the share price.
But P/Es don't exist in a vacuum. As you look at a company's P/E ratio, keep in mind the following things:
- P/Es vary by industry, so a P/E of 12 may be steep for a carmaker, while a P/E of 20 may be low for a specialized software developer. Always check historical industry averages.
- P/Es are tied to earnings, which companies can manipulate to some degree.
- Earnings can also fluctuate on many factors and move the P/E sharply.
To see whether a given P/E is actually low, compare it with the company's five-year average P/E. These companies, for example, are trading substantially below their historical average -- a suggestion that they're good candidates for further research.
|
Company
|
Recent P/E
|
5-Year Average P/E
|
|
eBay (Nasdaq: EBAY)
|
10
|
85
|
|
Halliburton (NYSE: HAL)
|
8
|
24
|
|
Yum! Brands (NYSE: YUM)
|
14
|
20
|
|
Adobe Systems (Nasdaq: ADBE)
|
15
|
37
|
|
Costco (Nasdaq: COST)
|
18
|
25
|
|
Dell (Nasdaq: DELL)
|
9
|
26
|
|
EMC (NYSE: EMC)
|
14
|
36
|
Data: MSNMoney.com
As you look at P/E ratios, make sure to review past years' EPS to make sure you're not looking at a current P/E that's very low because the EPS is unusually (and probably temporarily) high.
You can also compare a company's P/E with those of its peers. If it's significantly lower, either the company is facing some problems, or it might be a good buying opportunity.
In any case, P/E ratios are only one piece of the puzzle -- you'll need to do more research.
Price to sales
Another useful metric is the price-to-sales ratio (P/S), which divides the current market capitalization by the trailing year's revenue, also known as sales. This ratio tells you what the market is paying for each dollar of revenue, and like the P/E ratio, a high ratio signals excitements, while a low ratio signals disinterest.
The P/S ratio can be a handy alternative when a company hasn't yet posted earnings with which to calculate a P/E -- if it's sold just one ceramic chicken, they have revenue.
Like the P/E ratio, the P/S ratios can vary widely across industries. Companies with rich profit margins tend to support higher P/S ratios, so looking at net profit margins and historical P/S ratios will help you put any figure into perspective.
Remember that a low ratio by itself doesn't indicate a great value -- but it does suggest that further research is in order.
And ...
Other ratios, like the price-to-book ratio, the price-to-free cash flow ratio, and my old friend the PEG (price-to-growth) ratio, can also help you narrow down the universe of stocks that have recently seen their prices slashed to a short list of stocks worth the work of valuation.
Once you've narrowed the field, figuring out what a company's intrinsic value is and what kind of margin of safety you require is the next step. Our Motley Fool Inside Value service offers a handy DCF calculator to subscribers as well as monthly recommendations of stocks their calculations suggest are excellent bargains now. You can try it out with a 30-day free trial. Click here to get started -- there's no obligation to subscribe.
Longtime Fool contributor Selena Maranjian owns shares of eBay, Yum! Brands, and Costco. Dell and Costco are Motley Fool Inside Value selections. eBay and Costco are Stock Advisor recommendations. The Motley Fool is Fools writing for Fools.
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